A proposal by a consortium of major derivatives dealers to acquire London-based clearing house LCH.Clearnet has led to suggestions it could pose a conflict of interest.
BNP Paribas, HSBC, JP Morgan, Royal Bank of Scotland, Societe Generale and UBS, along with interdealer broker Icap are all thought to be involved in the consortium. Deutsche Bank will act as adviser on the acquisition, as well as being part of the bidding group. Sources say the final group could change, with other institutions, including the London Stock Exchange, expressing an interest.
The dealers will have to act fast. LCH.Clearnet signed a non-binding merger agreement on October 22 last year with the New York-based Depository Trust and Clearing Corporation (DTCC). Under the terms of the agreement, LCH.Clearnet shareholders would receive around EUR10 a share, valuing the firm at EUR739 million. The deal is due to be completed on March 15 - unless, that is, a counter offer is made.
With regulators pushing for greater use of central counterparties, particularly in the credit derivatives arena, some observers believe the proposed bid for LCH.Clearnet is an attempt by dealers to exert greater influence in the sector and prevent the takeover of a European clearing house by a US firm.
"Dealers may be obliged by regulators to move more of their business on to central counterparties and believe they have insufficient control of these entities in Europe. Eurex isn't really dealer-controlled, and while LCH.Clearnet has dealers in its ownership, the main credit default swap (CDS) players don't have any specific control there," says a senior clearing official at a European exchange.
LCH.Clearnet has 109 member firms but, if the consortium's bid is accepted, a far smaller number of dealers would be able to decide its governance and clearing criteria. This has led to concern about potential conflicts of interest. "Dealers can control who plays at the table, what games are played, and the level to which the smaller players can compete with them," the European clearing official continues.
The prospect of a dealer-owned clearing house has led some to question whether the structure could be modified to be advantageous to its owners - for example, allowing them to set favourable collateral or margining requirements. Margin might also be reduced as a result of increased competition in the clearing market.
"There are no minimum risk standards in the central counterparty industry in Europe because there is no regulator that supervises central counterparties across all jurisdictions. But this could be in danger now the European Commission wants central counterparties to compete. One likely area of competition will be margin," says Diana Chan, chief executive of Euro CCP, a European subsidiary of the DTCC.
Clearing houses should be market-neutral and not controlled by the very institutions conducting most of the trading, just as compliance and risk management within banks are typically separate from trading desks, argue critics of the consortium's proposed bid. Alberto Pravettoni, head of corporate strategy at LCH.Clearnet, says he understands these concerns: "It is important to question how representative a group of banks can be of the market. If three banks took ownership of LCH.Clearnet, then that would not be an appropriate market structure." He declined to comment on whether the size of the bidding dealer group would be appropriate.
Julien Kasparian, head of market infrastructure solutions at BNP Paribas Securities Services, agrees there would potentially be a conflict of interest if a small number of broker-dealers were to control a clearing house. "There is a conflict of interest if we have brokers governing a central counterparty that is supposed to be market-neutral and needs to manage the risk between the members. A broker that owns his own clearing business is a danger."
However, even if the consortium succeeds, a conflict of interest is not inevitable, Kasparian adds. Strict regulation of the dealers involved minimises the risk of dealers acting in their own interest.
Pravettoni agrees with that view. "LCH.Clearnet is subject to intense regulatory scrutiny. If we were to present a model that called for small margin payments because that is the desire of the owner banks, regulators simply wouldn't accept it," he says. "It is not in the commercial interest of banks to cut corners. If you take away the inherent integrity of the clearing house, you will undermine its purpose and the markets it serves. In such circumstances, everyone would be a loser."
Meanwhile, if the rival DTCC bid is successful, LCH.Clearnet will move to an at-cost governance model, with any excess revenue returned to users in the form of rebates, discounts or tariff reductions. Chan predicts this approach could have tangible risk management benefits.
"With at-cost governance, loss sharing serves as an inbuilt defence against moral hazard: if the margin collected is insufficient to cover a defaulting member, the surviving participants have to bear the consequences," she says. "A for-profit central counterparty is run like a business and there is a trade-off between risk and reward."
By contrast, a banker involved with the dealer consortium says the group is motivated by a desire to retain control over the derivatives business and to benefit financially. "The central counterparty will need to make a profit to create new products and protect participants by spreading the risk. Having a totally not-for-profit central counterparty may end up being unproductive," he says.